Mercer’s plan for integrating ESG

How to implement ESG into portfolio construction and implementation is an ongoing challenge for asset owners. Mercer has come up with a number of strategies including the best way to use ESG ratings, active ownership, and tailored strategies that play to sustainability themes, including its own unlisted investment solution. Amanda White spoke to Jane Ambachtsheer, global leader of responsible investment and Nick White, global director of portfolio construction research.

Much of the advancement in sustainable investing implementation has been at the big end of town; among large sophisticated asset owners with the ability to devote resources to the risks and opportunities.

But a back to basics approach by Mercer is now making ESG integration accessible for all investors, and has resulted in a new paper, “An investment framework for sustainable growth: capturing a broader set of risks and opportunities – integrating ESG and sustainable themes”, which outlines adoptable methods for ESG integration. (download the paper here ESG Framework)

“We wanted to take a step back to first principles and make sure we were not leaving too many people behind,” says Jane Ambachtsheer, global leader of responsible investment.

While there are still big regional differences both in sustainable philosophies and regulatory requirements, Ambachtsheer has seen a lot more interest in the implementation of ESG ideas in asset owner portfolios.

She stresses that no matter the path chosen that the first part of the process is a beliefs and implementation plan to make sure ESG takes on an appropriate role.

Essentially sustainability can be implemented through three tools: risk management, active ownership, and specific investment solutions.

From a risk management perspective, there are now up to 5,000 strategies with ESG ratings from Mercer, with only 10 per cent receiving the highest ratings (ESG1 or 2).

Nick White, global director of portfolio construction research, says investors need to understand what is going into those ratings, and how they can be used.

“A manager with a highly rated portfolio of ESG stocks might not be a good performer because it is not making the most of that,” he says. “By the same token we ask whether a quality manager, which has a great level of robustness, can be strengthened further by strengthening ESG.”

Mercer first began using ESG ratings within the responsible investment team in the late 2000’s. It soon became evident the ratings would be more powerful if they sat with the analyst and in 2010 they were integrated into research at the manager level.

Ambachtsheer’s team produced a lot of documentation around the expected investor behaviour for high rated ESG managers, and prepared case studies and questions for the researchers to ask. There was a lot of education and training of the Mercer analysts as the ESG ratings were integrated.

Now White says the ESG ratings are a complement to the conventional manager assessment, and while they are not an absolute determinant of an overall manager rating, if there are two A-rated managers, the one with the higher ESG rating will be preferred.

One of the services Mercer will engage with a client is a benchmarking, and gap analysis of their portfolio’s ESG ratings.

This then identifies the managers that are not performing and gives clients tools to either turnover the manager or influence them to change through engagement.

Engagement is the second tool that Mercer says that clients can use to implement sustainability, and Ambachtsheer says this comes back to the asset owners beliefs and priorities and it is important that time is spent on those so that engagement is not reactive.

“Engagement has made the most progress for asset owners,” she says, pointing to recent engagement by asset owners with oil and gas companies over expenditure on new reserves research. “But it is difficult to decide to engage until you have thought through your own position.”

The third area, and one where Mercer has spent a lot of time, is capturing the sustainability theme within investment solutions.

It is now in the manager selection stage of an unlisted global sustainability product that includes infrastructure and private equity around a broad range of sustainability themes including water, waste and natural resources.

It is essentially the implementation of Mercer’s Climate Change Asset Allocation Study.

“ESG is a factor like momentum or value. Targeting a sustainability theme is looking at where the growth is coming from,” White says. “We think it’s about understanding how the world is changing.”

There is a massive spectrum of understanding among investors about ESG, and White says the scrutiny around proof is so much more emphasised than in other sectors, but he believes there is a lot of evidence to say there is alpha in ESG, and points to the DB Advisors paper on Sustainable_Investing_2012.

“Alpha is revealed in different forms, for example it looks at ESG funds and shows they have lower cost of capital and higher accounting and market based performance,” he says.

Mercer is also seeing a lot of innovation in passive investment and is reviewing in detail the processes of passive managers, and will produce ESG ratings of passive managers later this year.